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Bull markets every now and then throw up stock market gurus. In the bull market that started from 2014, one name that came up frequently in discussions surrounding small caps is Porinju Veliyath, managing director and portfolio manager, Equity Intelligence India PMS. The Kochi-based investor shot to prominence as every small-cap he picked gave mind-numbing returns. It was as if he had a golden touch.

The 56-year old was even termed as India’s small-cap czar (or India’s Warren Buffett by some) and he has notched up several social media followers for his market views and also because of his political position. The self-professed expert has never shied away from hiding his admiration and love for Prime Minister Narendra Modi, while he has been extremely critical of the Congress governments through his social media outbursts.

Coming back to our story, the crash in small-cap stocks in the last year has thrown the cat among the pigeons. Porinju’s investment firm had accumulated nearly 5.4% of LEEL Electricals (well known for Lloyd brand) by October 2017. By end of February 2018, they held nearly 8% of the company’s equity. But, the investment did not pan out as planned. On January 11 this year, Porjinju in a letter to investors finally owned up for making a “mistake” with regards to LEEL Electricals stock, formerly Lloyd Electric & Engineering. The stock has dropped like nine pins and has now lost almost 80% of its value for most of Porjinju’s investors. Read on.

“Damage is done”

Porinju in a small time has acquired a cult-like status. Whether the LEEL Electricals episode will remain a taint on his skills is still undecided. But, the letter to investors provides a ring-side view of how storied fund managers analyse a stock and more importantly, how they make mistakes.

“Our investment in LEEL has witnessed a significant capital erosion and I admit that in hindsight it looks a mistake. My assumption that siphoning off in a changing regulatory environment would be difficult appears faulty. LEEL share price is nearly 80% low from the cost in most of the accounts. While we cannot rule out a possibility of eventual recovery in the share price, the damage has already been done,” Porinju wrote in his letter to investors.

“Rare but costly misjudgments like LEEL resulting in permanent loss of capital are humbling and thought-provoking for us in our pursuit to create wealth for our investors through long term value investing. Such flawed investments though big enough to be a drag on our investment journey, I am confident, would not deter us from creating wealth going forward,” the small-cap expert said, trying to strike a positive note.

Why Porinju bought LEEL

Porinju’s rise is a typical rag to riches story. Born in a lower-middle-class family in Chalakudy, near Thrissur, the ambitious man started his career in Mumbai as a floor trader with Kotak Securities in the 1990s. He then joined Parag Parikh Securities and just before 2000 moved back to Kochi. Within a few years, he founded Equity Intelligence, a fund management firm focused on value Investing in Indian equities.

In his investor letter, Porjinu has enumerated why he bought LEEL in the first place.

1. Cash from CD division sale – The company had received Rs 1,550 crore cash from the sale of Consumer Durable (CD) division to Havells and was trading at Rs 1,000 crore market cap (now Rs 182 crore).

2. Long term track record – Porinju says LEEL Electricals had a good long-term operating track record in air conditioning and white goods space, having successfully created and divested the “Lloyd” brand of appliances.

3. Core business good – Though the company had sold the brand “Lloyd” along with associated intangible assets, it had retained the operating assets including eight manufacturing facilities in India and abroad and was set to continue its business of being an OEM supplier to other major manufacturers.

4. An ecosystem for strong corporate governance – Post reforms like GST and demonetisation, corporate governance standards, law enforcement and business culture in India was improving and it was getting tougher to siphon off from public listed companies. Also subsequent to the Companies Act 2013, and various SEBI initiatives, the minority shareholder rights were getting stronger. Under these circumstances the likelihood of LEEL promoters siphoning off the cash received from the sale of CD division was low, says Porinju.

5. High expectations – Given the opportunities that the space in which LEEL operates and being cash rich, the most logical path for the promoters who have been in the business for around three decades, would have been to take the company to higher orbits and thereby creating wealth for all the stakeholders involved, Porinju had hoped.

What may have went wrong

Porjinu seems to have gone wrong on his assessment of the management quality aspect of LEEL Electricals.

In December 2017, the promoter of LEEL, Brij Raj Punj passed away and his son, Bharat Punj took over the reins of the company. “Throughout our interactions with Mr. Bharat Punj and other senior management in various occasions, they sounded optimistic about the business and future of the company, in line with our investment rationale. On 30th May 2018, to the shock of entire minority shareholders, including us, the company arbitrarily wrote back the profit from sale of CD division in FY18 annual results to Rs 663 crore, triggering a selloff in the stock,” Porinju says in the investor letter.

Porinju went on to suggest that LEEL Electricals committed illegal acts. “Company also diverted nearly Rs. 340 crore to promoter entities including the listed debt-laden entity Fedders Electric Ltd. as capex and loans for buying land and factories of their own plants. The stock fell from Rs 215 to Rs 127 in 5 days and the liquidity in the counter dried up,” he said.

Taken aback by such an unexpected development in the company, Equity Intelligence India reached out to the management for clarification, seeking more transparency and motivating them to share the wealth with minority shareholders. Given the value in company’s operations and assets, illiquidity in the counter, Equity Intelligence India’s significant holding and hoping for a better exit eventually, Porinju continued to hold the stock.

Porinju says despite Equity Intelligence India’s best efforts to engage the management, LEEL declined to share more details including the reconciliation of CD division sales proceeds and refused to reverse the malicious related party transactions.

“Losing hope on the management after months-long attempt, we decided to take up the issue with the authorities and engaged a leading corporate law firm in Mumbai to explore various legal remedies available and subsequently filed a complaint with SEBI – seeking a forensic audit of books of accounts of LEEL Electricals, without which the suspected fraudulent actions of the promoters and senior management to siphon off company’s wealth for personal enrichment cannot be proven legally,” the letter says.

Hope against hope

Porinju is hopeful that given the “circumstantial evidence of fraud involved”, the regulator would act judiciously, protecting interests of the entire minority shareholding community of the company, and set an exemplary precedent in the corporate governance history of Indian listed companies.

“In the two months after our complaint with SEBI, there have been several high levels exits from the company including many from senior management like the group CFO, Company Secretary, and VP Finance, Operations Director etc. The auditors of the company in 2Q19 results review report have asked the company management to review the receivables shown in the books. The impact of these events or of the regulatory action, if any, cannot be predicted.,” Porinju says.

Value of LEEL, in most of Equity Intelligence India accounts, has fallen below 3% of the account NAV. “Attempting to liquidate the investment at a time without liquidity in the counter will only lower the realizable value and this would not make any material positive impact to NAVs. Let me repeat – such flawed investments though big enough to be a drag on our investment journey, I am confident, would not deter us from creating wealth going forward,” the investor signed off.

It remains to be seen if Porinju can recoup at least a good part of his investment in LEEL, but the learnings from taking large bets on promoter-led Indian small caps have been a costly one.